Summary: Whatever happens during this recession, one thing is almost certain: the US government’s balance sheet will be trashed. Wrecked, perhaps beyond repair. This post discusses what we should do to mitigate the damage, and why such extreme spending is necessary.
As described in “The most important story in this week’s newspapers” (22 May 2008), the government has borrowed $6.4 trillion to finance past expenditures (aka “net public debt”, posted here). The government — us, collectively — owe an estimated $57 trillion in past promises to pay (the debt) AND future promises (social security, government pensions, medicare, etc).
That’s bad, perhaps beyond our ability to pay by means of future taxes. The alternatives are stark:
- cut expenses — the budget consists almost entirely of interest, defense/security, and social services.
- renege on our promises — cutting pensions, social security, medicare via taxation of benefits, and means-testing).
- inflation — reducing the debt in real terms.
- big tax increases.
None of these are easy or certain remedies. All may be necessary, and even together might be inadequate.
The worse news: we will run massive deficits over the next few years. Deficits of one or two trillion dollar deficits, for at least two or three years. Perhaps, if we continue to follow Japan’s path, for ten years or more. Since the boomers are already staring to retire — and the recession will force many into involuntary early retirement — this a bad time to be adding to the government’s debt load.
This makes it vital that we make good use of the government’s spending. We must focus on things that will generate cash in the medium-term to help pay-off the debt we are incurring.
Unfortunately the debasement of the English language (alternatively, its replacement by Newspeak) makes clear thinking difficult for us. Many folks have lost the idea that investment means spending cash to generate even more cash in reasonable short time with reasonable certainty. Instead they believe “investment” means “spending on things I like and hope will make the world a better place.” That way lies bankruptcy and ruin for our political regime, because this might be a very long downturn.
I strongly recommend reading the following, one of the most insightful essays about this crisis I have seen. These are words representing hard-earned experience, which we can either learn from — or repeat Japan’s mistakes. This is another powerful presentation from the Center for Strategic and International Studies (CSIS). Koo draws on Japan’s experience in the twenty years since their crash, explaining why the US might require years of massive fiscal stimulus — government spending — to keep the economy on life support until the private sector burns off its excess debt.
“‘Plan B’ for the Global Financial Crisis“, Richard C. Koo (Chief Economist of the Nomura Research Institute, Tokyo), presentation at the Center for Strategic and International Studies, 22 October 2008 — Here is a PDF of his slides. Bold emphasis added. Excerpt:
The on-going financial and economic difficulties in the US have not only defied many earlier forecasts of quick recovery, including those from the Fed, but are also showing signs of stress that many experts are calling the worst since the Great Depression. The ever worsening outlook, in turn, is multiplying the fear of both market participants and the general public, greatly worsening the deflationary pressure in the economy. The fact that European and Chinese real estate bubbles are also bursting at the same time is adding a global dimension to the problem.
The US (and the world) is extremely fortunate, however, in that Japan, the second largest economy in the world, had gone through something very similar just 15 years earlier, and its experience can tell us volumes about what to expect and what not to expect in this kind of recession. Although many Americans may balk at the idea that the US has something to learn from Japan, the truth of the matter is that the magnitude of the house price bubble in the US from 1999 to 2006 (138% increase) is virtually identical to the one Japan experienced between 1984 to 1991 (142% increase). Furthermore, according to the house price futures listed in Chicago Mercantile Exchange, the magnitude of the decline in house prices (33% decline from the peak in 4 years) will also be similar to the Japanese experience (37% decline from the peak in 4 years) 15 years earlier. This is shown in Exhibit 1.
Similarities do not end there. The largest estimate of losses financial institutions may incur in the current crisis was provided by the IMF in its October 2008 Global Financial Stability Report, which placed the price tag at $1.4 trillion of which $820 billion would be incurred by banks. The latter amount is close to the total non-performing loans Japanese banks wrote-off during the post-bubble period which was $952 billion at the exchange rate of 105 yen to the dollar.
Although the US has not experienced a “lost decade” yet, many signs are far worse in the US this time around compared to Japan 15 years ago. For example, the well criticized Japanese banking problems in the 90s never got to the point where the central bank has to enter the market for an extended period to make sure that banks are able to meet their daily payment responsibilities. In both the US and in Europe this time around, however, the lack of trust between the banks are so serious that central banks have been forced to provide liquidity directly to the banks for over a year, with no end in sight.
Although there are many differences between the Japanese and US experiences, the Japanese lessons provide the nearest thing to a roadmap of post-bubble-2 economy, and US policy makers will be able to greatly shorten the pain and suffering of the American people if they put those lessons to good use. In particular, the Japanese experience taught us that recessions brought about by the bursting of a nation-wide asset price bubble are fundamentally different from ordinary recessions in many key aspects
First, the bursting of a bubble invariably mean destruction of many private sector balance sheets as assets bought with borrowed funds collapse in value while the debt incurred to purchase those assets remain at their original values. Many businesses and households may find themselves with negative net worth. When these businesses and households start paying down debt or increase savings in order to regain their financial health and credit ratings, the economy enters what may be called “balance sheet recession” where monetary easing by the central bank fail to stimulate the economy or asset prices. Monetary policy loses its effectiveness because those with debt overhangs are not interested in increasing borrowing at any interest rate.
The Bank of Japan brought interest rates down from over 8% in 1991 to almost zero in 1995, but there was absolutely no response from the economy or asset prices which continued to weaken. Bernanke Fed brought interest rates down from 5.25% in September 2007 to 2% by April 2008 in the fastest monetary easing in Fed’s history, but the economy and house prices continued to fall. With so many banks and households in the US worried about the health of their balance sheets, further monetary easing by the Fed is likely to fare no better than the Japanese easing to zero interest rates 15 years earlier.
{FM Note: the actual Federal Funds rate has been from 1/4% to 1/2% rate since October 29, far below the “policy rate” of 1%.}
With nobody borrowing money and everybody paying down debt or increasing savings, even at zero interest rates, deflationary spiral becomes a real possibility in this type of recession. This is because those savings and debt repayments that are not borrowed and spent represent leakage to the income stream, and if left unattended, the economy will continue to lose aggregate demand equivalent to the unborrowed amount until either private sector balance sheets are repaired, or the sector has become too poor to save any money. The US fell into this spiral during the Great Depression, the worst balance sheet recession in history, and lost 46% of its GDP in just 4 years. Unemployment rate also rose to 25% by 1933.
… The Japanese GDP never fell in spite of massive fall in asset prices and massive increase in private sector debt repayment because the government borrowed and spent the increased savings and debt repayment. With the government actively putting this sum back into the income stream through its fiscal policy, there was no reason for the GDP to contract. In other words, Japan proved to the world that, even if real estate prices decline by 87% and the private sector is obsessed with debt minimization instead of profit maximization, it is still possible to keep the GDP from falling as long as government puts in an appropriate sized fiscal stimulus from the beginning and maintain that stance until private sector balance sheets are repaired.
… This means the key macro policy response in this type of recession should be an increase in government spending to keep the GDP from falling so that households and banks have the revenue to repair their balance sheets. Micro-economic responses, such as what to do with Fannie Mae or AIG are important, but they are no substitute for a comprehensive macro-economic response to maintain GDP because without revenue, no attempt to repair private sector balance sheets will succeed. Monetary easing is probably better than nothing, but it should not be relied on as the principle policy response when the private sector is minimizing debt and is in no position to respond to lower interest rates.
Not everything went well in Japan. Because the concept of balance sheet recession was not yet known in economics in the 90s, trial-and-error with largely ineffective monetary, structural and other policies continued. Moreover, because of the lack of conceptual understanding, the critical importance of fiscal policy in maintaining income stream in this type of recession was never fully appreciated, with the result that every time the economy showed signs of recovery with fiscal stimulus, it was assumed that the conventional pump-priming worked and the stimulus itself was cut “in order to rein on budget deficit.”
But no sustained recovery is possible in a balance sheet recession without the recovery of private sector balance sheets, and premature withdraw of stimulus invariably resulted in economic downturn. That prompted another fiscal stimulus, only to see it cut again after the improvement in the economy. This stop-and-go fiscal stimulus lengthened the total time of Japan’s recession by at least five years if not longer. A similar premature withdraw of fiscal stimulus in the US in 1937 also lengthened the duration of Great Depression until the onset of World War II.
The US will do well to make sure that this mistake is not repeated. In particular, Washington should enact a medium term (at least three to 5 years) seamless package of government spending to assure the public that they can count on the government to keep the economy going for the entire period. Such a commitment will go a long way in removing the fear of falling into a deflationary spiral and allow the private sector to plan for an orderly repair of its balance sheets. This stance of the government should be maintained until people are willing to borrow money again. If and when that point is reached, the government must embark on fiscal consolidation in order to avoid crowding out private sector investments.
Although more government spending means larger budget deficit, the Japanese experience indicate that the deficit will be far larger and the economy far weaker if the government failed to put private sector debt repayment and savings back into the economy’s income stream. The Japanese attempt in 1997 to reduce deficit, for example resulted in 5 quarters of negative growth and shocking 72% increase in budget deficit by 1999. The 2001 attempt to rein on deficit also resulted in weaker economy, falling tax revenue and larger deficit. These perverse results happen because in the absence of private sector investment demand, any reduction in government demand translates almost dollar-for-dollar to the reduction in aggregate demand, thus starting the deflationary cycle. In other words, in this type of recession, pro-active fiscal policy will result in higher GDP and lower deficit than reactive fiscal policy implemented after the economy had already collapsed.
Some may worry that, with savings as low as they are in the US today, who will buy the Treasury bonds issued to finance additional government spending? Some analysts argue that such concerns will raise interest rates in the US. Viewed from the perspective of balance sheet recession, however, these concerns are exaggerated. In this type of recession, the economic weakness is due to the private sector paying down debt or increasing savings in spite of ultra-low interest rates. The excess savings of the private sector therefore increases, and the economy weakens because no one in the private sector is willing to borrow and spend that money. Under these circumstances, the amount of borrowing and spending the government must engage in to keep the GDP from falling should be exactly the same as the sum of increased savings and debt repayments in the economy. As long as the fiscal stimulus is equal to the increase in private sector savings, it should not cause funding problems or lead to higher interest rates.
Koo continues on to discuss other aspects of this crisis. I recommend reading this in full, along with the slides.
Afterword
If you are new to this site, please glance at the archives below. You may find answers to your questions in these.
Please share your comments by posting below. Per the FM site’s Comment Policy, please make them brief (250 words max), civil, and relevant to this post. Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).
For more information from the FM site
To read other articles about these things, see the FM reference page on the right side menu bar. Of esp relevance to this topic:
- about the Financial crisis – what’s happening? how will this end?
- about the End of the post-WWII geopolitical regime
- some Good News about America!
Forecasts on the FM site about solutions to the crisis:
- A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
- A solution to our financial crisis, 25 September 2008
- A quick guide to the “Emergency Economic Stabilization Act of 2008″, 29 September 2008
- Prof Roubini prescribes first aid for America’s economy, 4 October 2008
- Effective treatment for this crisis will come with “The Master Settlement of 2009″, 5 October 2008
- Dr. Bush, stabilize the economy – stat!, 7 October 2008
- The new President will need new solutions for the economic crisis, 9 October 2008
- A brief note about our financial system: Intermediation, disintermediation, and soon re-intermediation, 16 October 2008
- New recommendations to solve our financial crisis (and I admit that I was wrong), 23 October 2008
- A look ahead to the end of this financial crisis, 30 October 2008
- Expect little or nothing from meetings like the G20 – or the Obama Administration, 18 November 2008
Have you read the latest release from Truth and Beauty (and Russian Finance)? The author raises an interesting problem that I haven’t heard mentioned yet: “Things that fall apart“, Eric Kaus, 21 November 2008.
“In simple terms (the only ones we understand) fully half of the US budget deficit will be required simply to pay interest on old debt.”
He predicts the only reasonable chance the US has is inflating the debt away by printing more money. I know you’ve predicted the same thing in the past Fabius and it looks like more people are coming around to this view.
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Fabius Maximus replies: This has been a often-discussed worry for a long time, and the current skyrocketing US government debt has brought us near the point at which the debt enters a death-spiral: we have to borrow to pay the interest.
Also note: the average maturity of the US government’s debt is quite short, which makes us vulnerable to a rise in interest rates — which would greatly increase our interest payments. So the debt is both large and structured in an unstable fashion.
The problem with the United States today is that, as Gertrude Stein said of Oakland, “There’s no “there,” there.”
Increasingly the United States is simply an arbitrary swath of land on the North American continent. Old forms no longer function. What you are describing is a symptom of this.
Rather than trying to trying to make sense out of politics or out of economics, we need instead to retreat to establish what makes sense, period. Only then can it be possible to figure out how to formalize things.
The Culture of Life News here!
One of my readers sent me this link. I have been writing about all this for years. The present collapse was quite visible back in 2000.
That was the year Bush waved some dollars as he explained how his tax cuts would NOT cause epic deficit spending. We finally, thanks to funds pouring into the government’s coffers, had a balanced budget for exactly one year. Predictions were made that at that rate, the US would have to cut taxes due to the flood of tax money coming in. Why, this would destroy the Federal Reserve due to a fall in US Treasuries which are 100% debt. Well, we got the Bush solution to that problem: infinite debts that we have no intention of paying off.
The results were obvious from day one. Congress merrily went on an epic spending spree. The wars were a great way to burn through a trillion dollars. We are still burning up money in Afghanistan and Iraq.
Now, here we are, more than double debt since Bush waved the dollars. And it is TREBLING. We spent wildly on imports and government misspending during the bubble years. Now, we are doing this twice as bad in bad years.
This takes us to another stupid thing: one should pay down debts in good times so we have CREDIT to take on debts in bad times. Instead, we run up debts in good times and then struggle to pay them off in bad times!
This time around, thanks to the New Economics Delusions put up by Bernanke and his ilk, we are going to take on infinite debt in order to fix a problem caused by too much debt during good times. This ends with our empire going bankrupt. Which China plans for us. I hosted the Chinese leadership many years ago when they wanted to learn about capitalism after they arrested Madame Mao. My father was one of the first US operatives to go to China with Nixon.
So back then, once I convinced them about how capitalism and especially, banking, works, they told me, they would strive to be the bankers for the US and thus disarm us peacefully when we go bankrupt! This was in 1984.
They then cooked up the 50 year plan: we are half way on this plan and in good time, we will end up where they want us: on the floor. The new deficit spending is accelerating this so much, the 50 year plan will finish before 2020 rather than in 2034. Isn’t this pathetic?
So we replace private debt with public debt? And what do we do if the total amount of debt is at an unhealthy level?
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Fabius Maximus replies: Good question. This can work if we are burning off the excess private debt thru bankruptcy. Triage, saving what we can. A mass shift of debt from private to public, like we are doing with the finanical sector (and perhaps the auto industry) is IMO idiotic (at best). As described in these posts:
Slowly more voices are raised about the pending theft of taxpayer money, 21 September 2008
* The Paulson Plan will buy assets cheap, just as all good cons offer easy money to the marks, 30 September 2008
* A reminder – the TARP program is just theft, 24 November 2008
I don’t see how bankruptcies change anything.
If Party A loans money to Party B, and B goes bankrupt, B’s balance sheet problems just shift to A. A might be in a position to absorb those problems, but not without going through the same sort of belt-tightening that A would have gone through if it had enough capital to ride out the recession. Either way, you’re looking at “savings and debt reduction” which Koo says we should match with increased public debt.
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Fabius Maximus replies: Look at this in simple terms. The problem is the excess debt, which must go away somehow. Our goal is to have the resulting loss absorbed with minimal impact on the economy. The factors to be stabilized are bank lending and the nation’s aggregate spending.
* Loan defaults hurts banks and investors (e.g., mortgage-backed securities in all their forms).
* Banks can be bankrupted — with bank depositors and bondholders protected by government money; holding company bondholders and shareholders wiped out — and reopened under new ownership (either the government or sold to another bank). That keeps the banks in business and making loans.
* Investor losses reduce aggregate spending via the wealth effect, which is mitigated (i.e, partially offset) by government spending (aka fiscal stimulus).
Empire of Roma, c. 2200 yr. ago devalued coins. . .
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Fabius Maximus replies: And your point is? Devaluing coins is causes inflation but with little long-term gain. Just like devaluation of fiat money. Inflation is easy to do but difficult to successfully use as a policy tool.
Maybe his point was that inflation can not be “cured” by returning to the ‘gold standard?”
You say partially offset. If the goal is to maintain GDP (which Koo seems to focus on), Koo says it needs to be fully offset. Do you disagree with him?
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Fabius Maximus replies: Nice goal. I doubt it is possible for us. We shall see.
I’m confused. You say you like his goal, but you say the means are “idiotic at best”.
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Fabius Maximus replies: In my reply to your comment #5 I said we need to do two things.
* Bankrupt and reopen failed financial institutions
* Government spending (aka fiscal stimulus) to mitigate the decline in aggregate demand.
We have done neither of these things during this downturn, with the exception of the poorly-designed tax rebate in the 2nd quarter of this year. Congress will pass a stimulus bill in December, I hope, and a larger one early next year. The first will be too little, the second too late — so a hard downturn is probably inevitable at this point.
What Paulson and Bernanke have done is poor astonishing sums into the broken financial system — close to $2T and rising. This has bailed out their executives, shareholders (with too-few exceptions), and bondholders of banks and GSE’s (good) — non-banks too (at no benefit to the taxpayers).
Ok, but for the purposes of this conversation, I don’t care what has or has not been done. I’m focusing strictly on the theory.
Koo seems to advocate replacing the lost private demand via fiscal stimulus. You keep saying “mitigate” and “partially offset”. Is this a real disagreement between you two? Is there significance to it?
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Fabius Maximus replies: That’s nice. I am not talking about the theory, as the essence of our situation is that we are beyond the operating envelope of current Keynesian theory — in which aggregate debt levels are not a significant parameter. That’s why we are here. Like the 1930’s, having weak theory makes both forecasting and finding solutions difficult.
Can we duplicate Japan’s experience with debt deflation? Perhaps, if…
* if we entered this downcycle with a domestic HH savings rate of +25% instead of -5%,
* if we entered this downcycle with a net government debt of 25% instead of 40%,
* if we could run net government debt up to 120% of GDP, like Japan did,
* if we had a large net foreign creditor balance, instead of being the #1 debtor,
* if we ran a current account balance of +5% instead of -5%, and
* if the boomers were starting to retire in 2020 instead of right now.
If the differences between Japan and us are so different as to render the comparison meaningless, why did you “strongly recommend” Koo’s article?
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Fabius Maximus replies: Probably for the reasons I stated. Since we have the same underlying problem…
* We too will be running large deficits.
* We too probably will take years to burn off the excess debt.
* Hence large fiscal stimulus will be necessary for several years, perhaps longer.
And: This makes it vital that we make good use of the government’s spending. We must focus on things that will generate cash in the medium-term to help pay-off the debt we are incurring.
Japan made two mistakes in the 1990’s, neither of which we can afford (the 2nd will be discussed in a future post):
(1) They in effect just burned the money, building much unneccessary infrastructure that generates neither cash nor social benefits.
(2) They repeatedly stopped the simulus (increased taxes, reduced spending), throwing their economy into sudden stop mode.
Then then comparison is valid and we’re right back to my first question. The “burn-off” is equal to the difference between the decrease in private debt and the increase public debt.
Koo says they should be equal, resulting in no burn-off. You expect there to be some. If we’re putting government in charge of deciding the economy’s aggregate debt level, it’s fair to ask how it plans to decide on the “right” amount.
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Fabius Maximus replies: Good question. This is complex, but I’ll take a shot at a brief explanation. As I said, we are beyond both theory and reliable precedents.
(1) I can see why you say this, but that is not what he means (it might have been clear in Japanese in his draft). Japan’s fiscal stimulus offset the falling in aggregate demand resulting from the debt deflation (not equal to the debt deflation), so GDP remains stable while private balance sheets “heal.”
(2) I don’t know what happened to Japan’s aggregate debt during this period; the numbers I see don’t agree. But it has probably increased. Japan’s success is stable GDP during a 20-year battle with deflation. Recovery requires growth, and that they never managed.
But the cost to Japan has been a 5x increase in government debt – more than offseting the decline in corporate debt from 150% GDP to 100% (or 115% to 90%, or whatever). Household debt is flatish. (These numbers are from my sketchy files, but are likely more or less right)
This poor response was predicted by Karel van Wolferen in his book “The Enigma of Japanese Power” (1989), saying that Japan would fail its next serious crisis because it could not respond to change:
The current global recession might have unpleasant effects on Japan. Their demographic trends are ominous, their economy weak.
I said, “This can work if we are burning off the excess private debt thru bankruptcy” Or even, cross our fingers, paying it off. Or inflating it away. For more on these options see “A happy ending to the current economic recession.” (12 February 2008).
We might not do as well as Japan (as a debtor nation, deflation is far more dangerous to us). Or, perhaps we’ll do better. Who can say what we will do, let alone what success we’ll have?
FM: I’m sure you’re half correct about the first thing to do, bankrupt failed financial institutions. What I don’t see in Japan, nor in your comments, is any analysis about labor. I also now remember that almost none of the Great Depression blog posts recently discuss labor much — how the late 20s – 30s saw quite a shift away from farm work into everything else.
The house value bubble, and the derivative super-bubble on top, created huge bubble profits in the financial sector, and far too many folks were hired. What do house construction workers do when there’s too many houses? Other kinds of medium-low paid manual work. What do bankers do when there’s no more bubble asset wealth to manage (and collect fees on)?
Citi just released 50 000. There needs to be a big, Big, BIG contraction in people working in finance. So your point #1 second half, re-open failed finance firms, is probably wrong. No need for as many MBS instruments, nor other products or derivatives. However, the gov’t should continue to lubricate (with low interest rate cash) banks that are lending to non-finance companies.
I’d even argue that TARP could usefully be used as 1% loans to all banks who lended money to production companies in the last quarter or half year or year — in the same amount as they lent. This should be pretty attractive to the many small solvent banks, and those are the lenders the gov’t should be helping out.
Not the excessively big, fat, failed companies that now should die.
Your second point is important: gov’t spending to pump up aggregate demand.
My own third point remains: house prices need to be stable.
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Fabius Maximus replies: Your fondness for the policies of the early Hoover administration is amazing, but not worth replying to again.
When saying that I am wrong, please at least attempt to quote me correctly. I said
This says nothing about keeping the full staff of every institution. It’s not as if this needs to be spelled out, given the long history of bank reorganizations — and business reorgs in general; staff is almost always reduced.
Also, this is a series of articles, and I have not yet worked along to discussion of labor. You mention some important aspects of the problem. Unemployed workers today — vs. the 1930’s — are more likely to be older and in specialized fields. Putting them to work building trails and parks will not work too well. Also construction is more specialized. Massive works projects probably will help only the people in a narrow slice of the economy — and attract tens of thousands of illegal aliens to do the hard labor.
When our experts suggested money supply expansion and corresponding inflation as a way to deal with Japan’s liquidity trap, apparently a misdiagnosis but still good advice, their response was, “No.” “If we do, our elderly who are living on fixed incomes will vote us out of office in a New York minute”. They, and us, were living in a very imperfect world.